Thursday, March 06, 2014

Redistribution, inequality, and sustainable growth: Reconsidering the evidence, by Jonathan D Ostry, Andrew Berg, and Charalambos Tsangarides, Vox EU: Rising income inequality looms high on the global policy agenda, reflecting not only fears of its pernicious social and political effects (including questions about the consistency of extreme inequality with democratic governance), but also its economic implications. While positive incentives are surely needed to reward work and innovation, excessive inequality is likely to undercut growth – for example by undermining access to health and education, causing investment-reducing political and economic instability, and thwarting the social consensus required to adjust in the face of major shocks.

Understandably, economists have been trying to understand better the links between rising inequality and the fragility of economic growth. Recent narratives include how inequality intensified the leverage and financial cycle, sowing the seeds of crisis (Rajan 2010), or how political-economy factors – especially the influence of the rich – allowed financial excess to balloon ahead of the crisis (Stiglitz 2012).

But what is the role of policy – and in particular fiscal redistribution – in bringing about greater equality? Conventional wisdom suggests that redistribution would in itself be bad for growth, but by reducing inequality, it might conceivably help growth. Looking at past experience, we find scant evidence that typical efforts to redistribute have on average had an adverse effect on growth. Moreover, faster and more durable growth seems to have followed the associated reduction in inequality.

Disentangling the effects of inequality and redistribution on growth

In earlier work (Berg and Ostry 2011), we documented a robust medium-run relationship between equality and the sustainability of growth. We did not, however, have much to say on whether this relationship justifies efforts to redistribute.

Indeed, many argue that redistribution undermines growth, and even that efforts to redistribute to address high inequality are the source of the correlation between inequality and low growth. If this is right, then taxes and transfers may be precisely the wrong remedy – a cure that may be worse than the disease itself.

The literature on this score remains controversial. A number of papers (e.g. Benabou 2000) point out that some policies that are redistributive – e.g. public investments in infrastructure, spending on health and education, and social insurance provision – may be both pro-growth and pro-equality. Others are more supportive of a fundamental tradeoff between redistribution and growth, as argued by Okun (1975) when he referred to the efficiency ‘leaks’ that come with efforts to reduce inequality.

In a new paper (Ostry et al. 2014), we ask what the historical data say about the relationship between inequality, redistribution, and growth. In particular, what is the evidence about the macroeconomic effects of redistributive policies – both directly on growth, and indirectly as they reduce inequality, which in turn affects growth?

To disentangle the channels, we make use of a new cross-country dataset that carefully distinguishes net (post-tax and transfers) inequality from market (pre-tax and transfers) inequality, and allows us to calculate redistributive transfers for a large number of countries over time – covering both advanced and developing countries. We analyse the behaviour of average growth during five-year periods, as well as the sustainability and duration of growth.

Our key questions are empirical. How big is the ‘big tradeoff’? How does the direct (in Okun’s view negative) effect of redistribution compare to its indirect and apparently positive effect through reduced inequality?

Some striking results on the links between redistribution, inequality, and growth

First, we continue to find that inequality is a robust and powerful determinant both of the pace of medium-term growth and of the duration of growth spells, even controlling for the size of redistributive transfers.

Thus, it would still be a mistake to focus on growth and let inequality take care of itself, if only because the resulting growth may be low and unsustainable. Inequality and unsustainable growth may be two sides of the same coin.

Second, there is remarkably little evidence in the historical data used in our paper of adverse effects of fiscal redistribution on growth.

The average redistribution, and the associated reduction in inequality, seem to be robustly associated with higher and more durable growth. We find some mixed signs that very large redistributions may have direct negative effects on growth duration, such that the overall effect – including the positive effect on growth through lower inequality – is roughly growth-neutral.

Caveats

These findings may suggest that countries that have carried out redistributive policies have actually designed those policies in a reasonably efficient way. However, it does not mean of course that countries wishing to enhance the redistributive role of fiscal policy should not pay attention to efficiency considerations. This is especially important for countries with weak governance and administrative capacity, where developing tax and spending instruments that can allow governments to undertake redistribution efficiently are of the essence. A forthcoming paper by the IMF will delve into these fiscal issues.

Of course, we should also be cautious about drawing definitive policy implications from cross-country regression analysis alone. We know from history and first principles that after some point redistribution will be destructive to growth, and that beyond some point extreme equality also cannot be conducive to growth. Causality is difficult to establish with full confidence, and we also know that different sorts of policies are likely to have different effects in different countries at different times.

Bottom line

The conclusion that emerges from the historical macroeconomic data used in this paper is that, on average across countries and over time, the things that governments have typically done to redistribute do not seem to have led to bad growth outcomes. Quite apart from ethical, political, or broader social considerations, the resulting equality seems to have helped support faster and more durable growth.

To put it simply, we find little evidence of a ‘big tradeoff’ between redistribution and growth. Inaction in the face of high inequality thus seems unlikely to be warranted in many cases.

References

Benabou, R (2000), “Unequal Societies: Income Distribution and the Social Contract”, The American Economic Review, 90(1): 96–129.

Redistribution, inequality, and sustainable growth: Reconsidering the evidence, by Jonathan D Ostry, Andrew Berg, and Charalambos Tsangarides, Vox EU: Rising income inequality looms high on the global policy agenda, reflecting not only fears of its pernicious social and political effects (including questions about the consistency of extreme inequality with democratic governance), but also its economic implications. While positive incentives are surely needed to reward work and innovation, excessive inequality is likely to undercut growth – for example by undermining access to health and education, causing investment-reducing political and economic instability, and thwarting the social consensus required to adjust in the face of major shocks.

Understandably, economists have been trying to understand better the links between rising inequality and the fragility of economic growth. Recent narratives include how inequality intensified the leverage and financial cycle, sowing the seeds of crisis (Rajan 2010), or how political-economy factors – especially the influence of the rich – allowed financial excess to balloon ahead of the crisis (Stiglitz 2012).

But what is the role of policy – and in particular fiscal redistribution – in bringing about greater equality? Conventional wisdom suggests that redistribution would in itself be bad for growth, but by reducing inequality, it might conceivably help growth. Looking at past experience, we find scant evidence that typical efforts to redistribute have on average had an adverse effect on growth. Moreover, faster and more durable growth seems to have followed the associated reduction in inequality.

Disentangling the effects of inequality and redistribution on growth

In earlier work (Berg and Ostry 2011), we documented a robust medium-run relationship between equality and the sustainability of growth. We did not, however, have much to say on whether this relationship justifies efforts to redistribute.

Indeed, many argue that redistribution undermines growth, and even that efforts to redistribute to address high inequality are the source of the correlation between inequality and low growth. If this is right, then taxes and transfers may be precisely the wrong remedy – a cure that may be worse than the disease itself.

The literature on this score remains controversial. A number of papers (e.g. Benabou 2000) point out that some policies that are redistributive – e.g. public investments in infrastructure, spending on health and education, and social insurance provision – may be both pro-growth and pro-equality. Others are more supportive of a fundamental tradeoff between redistribution and growth, as argued by Okun (1975) when he referred to the efficiency ‘leaks’ that come with efforts to reduce inequality.

In a new paper (Ostry et al. 2014), we ask what the historical data say about the relationship between inequality, redistribution, and growth. In particular, what is the evidence about the macroeconomic effects of redistributive policies – both directly on growth, and indirectly as they reduce inequality, which in turn affects growth?

To disentangle the channels, we make use of a new cross-country dataset that carefully distinguishes net (post-tax and transfers) inequality from market (pre-tax and transfers) inequality, and allows us to calculate redistributive transfers for a large number of countries over time – covering both advanced and developing countries. We analyse the behaviour of average growth during five-year periods, as well as the sustainability and duration of growth.

Our key questions are empirical. How big is the ‘big tradeoff’? How does the direct (in Okun’s view negative) effect of redistribution compare to its indirect and apparently positive effect through reduced inequality?

Some striking results on the links between redistribution, inequality, and growth

First, we continue to find that inequality is a robust and powerful determinant both of the pace of medium-term growth and of the duration of growth spells, even controlling for the size of redistributive transfers.

Thus, it would still be a mistake to focus on growth and let inequality take care of itself, if only because the resulting growth may be low and unsustainable. Inequality and unsustainable growth may be two sides of the same coin.

Second, there is remarkably little evidence in the historical data used in our paper of adverse effects of fiscal redistribution on growth.

The average redistribution, and the associated reduction in inequality, seem to be robustly associated with higher and more durable growth. We find some mixed signs that very large redistributions may have direct negative effects on growth duration, such that the overall effect – including the positive effect on growth through lower inequality – is roughly growth-neutral.

Caveats

These findings may suggest that countries that have carried out redistributive policies have actually designed those policies in a reasonably efficient way. However, it does not mean of course that countries wishing to enhance the redistributive role of fiscal policy should not pay attention to efficiency considerations. This is especially important for countries with weak governance and administrative capacity, where developing tax and spending instruments that can allow governments to undertake redistribution efficiently are of the essence. A forthcoming paper by the IMF will delve into these fiscal issues.

Of course, we should also be cautious about drawing definitive policy implications from cross-country regression analysis alone. We know from history and first principles that after some point redistribution will be destructive to growth, and that beyond some point extreme equality also cannot be conducive to growth. Causality is difficult to establish with full confidence, and we also know that different sorts of policies are likely to have different effects in different countries at different times.

Bottom line

The conclusion that emerges from the historical macroeconomic data used in this paper is that, on average across countries and over time, the things that governments have typically done to redistribute do not seem to have led to bad growth outcomes. Quite apart from ethical, political, or broader social considerations, the resulting equality seems to have helped support faster and more durable growth.

To put it simply, we find little evidence of a ‘big tradeoff’ between redistribution and growth. Inaction in the face of high inequality thus seems unlikely to be warranted in many cases.

References

Benabou, R (2000), “Unequal Societies: Income Distribution and the Social Contract”, The American Economic Review, 90(1): 96–129.